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Thursday, April 26, 2012

Fed Chairman Ben Bernanke was asked yesterday in the post-FOMC press conference whether the Fed's response to the current economic crisis is consistent with his views as an academic. The context for this question was Paul Krugman's recent article where he noted that Bernanke was not following his own advice in the late 1990s where he argued that Japanese monetary authorities should be doing more to restore aggregate demand. Here is how Bernanke answered the question:

So there’s this view circulating that the views I expressed about 15 years ago on the Bank of Japan are somehow inconsistent with our current policies. That is absolutely incorrect. My views and our policies today are completely consistent with the views that I held at that time.

I made two points at that time to the Bank of Japan. The first was that I believe that a determined central bank could and should work to eliminate deflation, that is, falling prices. The second point that I made was that when short-term interest rates hit zero, the tools of a central bank are no longer — are not exhausted. There are still other things that — that the central bank can do to create additional accommodation.

Now, looking at the current situation in the United States, we are not in deflation... So the — the very critical difference between the Japanese situation 15 years ago and the U.S. situation today is that Japan was in deflation.

So Bernanke responds that he is being consistent because in Japan there was deflation whereas currently there is none. But as Ryan Avent notes, his research on Japan was about more than deflation--it was about a shortage of aggregate demand. This point can be easily seen by looking at his 1999 paper where he discusses Japan's economic problems. The first section after the introduction reads as follows:

Diagnosis: An Aggregate Demand Deficiency

Before discussing ways in which Japanese monetary policy could become more expansionary, I will briefly discuss the evidence for the view that a more expansionary monetary policy is needed. As already suggested, I do not deny that important structural problems, in the financial system and elsewhere, are helping to constrain Japanese growth. But I also believe that there is compelling evidence that the Japanese economy is also suffering today from an aggregate demand deficiency. If monetary policy could deliver increased nominal spending, some of the difficult structural problems that Japan faces would no longer seem so difficult.

If the section header is not obvious enough, the first paragraph makes clear that Bernanke believed there was a serious "aggregate demand deficiency" problem in Japan. Deflation is nowhere in that lead paragraph. It only appears later as one of several indicators of the AD deficiency. Bernanke even mentions in the paper that using deflation as indicator of weak AD can be problematic:

Perhaps more salient, it must be admitted that there have been many periods (for example, under the classical gold standard or the price-level-targeting regime of interwar Sweden) in which zero inflation or slight deflation coexisted with reasonable prosperity.

Deflation is tricky because it can be caused by both a negative aggregate demand shock or a positive aggregate supply shock. In other words, deflation is only a symptom of the underlying problem Bernanke is concerned about. And, as Bernanke reports, outright deflation occurred only a few years in the 1990s, with most of the deflation instances falling just shy of 0%. In other words, the1990s Japan was not a decade of sharp deflation. This decade actually had a slightly positive rate of inflation on average:

That is why Bernanke turns to other indicators in his paper to support his story of AD deficiency. For example, here he turns to direct measures of AD to make the case:

Alternative indicators of the growth of nominal aggregate demand are given by the growth rates of nominal GDP (Table 1, column 4) and of nominal monthly earnings (Table 1, column 5). Again the picture is consistent with an economy in which nominal aggregate demand is growing too slowly for the patient’s health.

In short, Bernanke's interest in the troubled Japanese economy was not motivated by deflation concerns, but by AD deficiency concerns. And by this criteria, the Bernanke Fed is not following Bernanke's monetary policy prescriptions for Japanese monetary authorities. This can be seen in the table above that shows average NGDP growth in the United States since 2008 is similar to the low average NGDP growth rate in Japan over the time period covered in Bernanke's paper. Moreover, the deviation of U.S. NGDP growth from its expected path in 2011 is not too different from the deviation of Japanese NGDP growth from its expected path in the late1990s.

In other words, Bernanke's Japanese AD deficiency problem in 1999 is very similar to the current U.S. AD deficiency problem. And contrary to the claims of some Fed officials, this current AD deficiency could be addressed without risking the Fed inflation-fighting credibility by adopting a price level or NGDP level target. Sigh.

P.S. A big thanks to Binyamin Applebaum of the New York Times for asking Bernanke the question.

Tuesday, April 24, 2012

Many observers have been baffled by the transformation of Ben Bernanke the academic who argued the Bank of Japan in the 1990s was not trying hard enough to restore aggregate demand to Ben Bernanke the central banker who now seems to be making the same mistakes for which he criticized the the Japanese. This has created numerous discussions over the past few years and now Paul Krugman has a new article on it where nicely coins this phenomenon as the Bernanke Conundrum:

The Bernanke Conundrum — the divergence between what Professor Bernanke advocated and what Chairman Bernanke has actually done — can be reconciled in a few possible ways. Maybe Professor Bernanke was wrong, and there’s nothing more a policy maker in this situation can do. Maybe politics are the impediment, and Chairman Bernanke has been forced to hide his inner professor. Or maybe the onetime academic has been assimilated by the Fed Borg and turned into a conventional central banker. Whichever account you prefer, however, the fact is that the Fed isn’t doing the job many economists expected it to do, and a result is mass suffering for American workers.

My best guess is that the disappointing response of the Bernanke Fed represents the effects of both bullies and the Borg, a combination of political intimidation and the desire to make life easy for the Fed as an institution. Whatever the mix of these motives, the result is clear: faced with an economy still in desperate need of help, the Fed is unwilling to provide that help. And that, unfortunately, makes the Fed part of a broader problem.

One of the key reasons for political intimidation is an inordinate fear of inflation. What these inflation critics miss is that the Fed could actually raise the level of aggregate nominal spending by a meaningful amount without jeopardizing long-run inflation expectations. This is possible if one uses a price level or a NGDP level target that provides a credible nominal anchor. Since the inflation critics seem to miss this point let me again explain it using my preferred approach, a NGDP level target.

Under a NGDP level target a central bank would commit to keeping aggregate nominal spending on some targeted growth path, say 5%. Such a rule would, therefore, anchor long-run inflation expectations. It would also allow for aggressive catch-up growth (or contraction) in NGDP so that past misses in aggregate nominal spending growth would not cause NGDP to permanently deviate from its targeted growth path. In other words, past NGDP growth mistakes would be corrected. The following figure illustrates this idea:

The black line has NGDP growing at a 5% annualized rate. Then, at time t a negative aggregate demand (AD) shock causes NGDP to contract through time t+1. There is now an a NGDP shortfall. To make up for it, the Fed must actually grow NGDP significantly faster than 5% to return aggregate nominal spending to its targeted level. For example, if NGDP fell 6% between t and t+1 it is now 11% under its trend. Next period the Fed must make up for the 11% shortfall plus the regular 5% growth for that period. In short, the Fed would need to grow NGDP about 16% between t+1 and t+2 to get back to trend. This temporary burst in NGDP would probably make the inflation critics nervous, but they shouldn't be. There might be temporarily higher inflation as part of the rapid NGDP growth, but over the long-run a NGDP level target would settle back at 5% growth. Nominal expectations would be firmly anchored.

But even then, some higher inflation over the short run would actually be justified. For it would restore nominal incomes to where they were expected to be when debtors and creditors agreed to nominal contracts prior to the the negative AD shock. Similarly, it would return real debt burdens to the path expected when the contracts were first signed. Moreover, the real growth likely to result from the aggressive catch-up NGDP growth would ultimately push up yields giving savers the returns they were expecting before the shock. Remaining on the dashed line, where there is no catch-up growth, would keep yields depressed.

If level targeting were more widely understood I suspect there would be no Bernanke Conundrum.

Update: The implication of the above discussion is that the Fed has allowed NGDP to fall to the dashed line as seen here. Also, Marcus Nunes discusses Paul Krugman's piece.

Wednesday, April 18, 2012

Last year Christina Romer argued that Fed chairman Ben Bernanke needed a Volcker moment. What she meant is that like Paul Volcker in the early 1980s, Bernanke needs to rise to the occasion and adopt a new monetary regime radical enough to solve the big economic problem of the day. For Paul Volker the problem was ever increasing inflation and the new monetary regime was targeting bank reserves. For Ben Bernanke the problem is an ongoing aggregate demand slump and the new monetary regime would be nominal GDP (NGDP) level targeting. As someone who believes in NGDP level targeting, I too have been hoping the Ben Bernanke will have a Volcker moment. After all, it would not be too much of a stretch for him given his work on Japan. But he has not and therefore continues to keep Fed policy effectively tight as it has been since mid-2008. Fed vice-chairwoman Janet Yellen acknowledges as much. Tim Duy considers this to be maddening monetary policy, Karl Smith views it an utter policy failure, and Ryan Avent is banging his head in frustration over it.

Maybe it is time for us to admit that Bernanke will never have his Volcker moment. He has had many opportunities and whether because of groupthink at the Fed, political power of savers, or a failure by him to read Scott Sumner's blog, Bernanke cannot seem to find his Volcker moment. It is not clear he ever will. So instead of hoping Bernanke has a Volker moment, maybe we should be hoping for President Obama to have a FDR moment.

The FDR moment occurred in 1933 when FDR took the reigns of monetary policy from an ineffective Fed and sparked a robust recovery in aggregate demand. The Fed had allowed aggregate demand to collapse for three years when FDR responded. He signaled that he wanted the price level to return to its pre-crisis level (i.e. increased expectations of higher nominal spending) and acted upon it by having the Treasury Department devalue the gold content of the dollar. This dramatically increased the monetary base and spurred a sharp increase in aggregate demand.

So how could President Obama have his FDR moment? Like FDR, he should signal his intentions for higher level of nominal spending and follow through on it by having the Treasury Department take take the reigns of monetary policy from the Fed. President Obama could do this by announcing a NGDP level target that would be implemented by the Treasury Department creating large-denomination platinum coins that would be deposited at the Fed and used to fund checks to the public. The Treasury Department would keep making these coins until the the NGDP level target was hit. If NGDP went above the target the Treasury Department would issue bonds to withdraw the excess money.

Okay, that is a radical idea coming from me. It is a mongrel mix of Market Monetarism and Modern Monetary Realism. It is not my first choice of the Fed adopting a NGDP level target, but it should work. It makes use of expectations management which should minimize the number the actual number of platinum coins needed and if used as a threat it might even cause Bernanke to suddenly discover his Volcker moment.

Thursday, April 12, 2012

Vice Chair of the Fed Janet Yellen looks at a number of monetary policy rules and concludes that U.S. monetary policy has been too tight (my bold):

[R]esource utilization rates have been so low since late 2008 that a variety of simple rules have been calling for a federal funds rate substantially below zero, which of course is not possible. Consequently, the actual setting of the target funds rate has been persistently tighter than such rules would have recommended. The FOMC's unconventional policy actions--including our large-scale asset purchase programs--have surely helped fill this "policy gap" but, in my judgment, have not entirely compensated for the zero-bound constraint on conventional policy. In effect, there has been a significant shortfall in the overall amount of monetary policy stimulus since early 2009 relative to the prescriptions of the simple rules that I've described.

Finally, a prominent Fed official acknowledges what Market Monetarists have been saying for some time: over the past 3 years the Fed has failed to adequately ease monetary policy and thus has passively tightened. Fed chairman Ben Bernanke acknowledges this possibility, but for obvious reasons is less willing to admit that the Fed is guilty of it. What Yellen and Bernanke both need to embrace is a NGDP level target. This approach would allow the Fed to make up the cumulative shortfall created by the Fed's passive tightening while at the same time keeping long-term inflation expectations anchored. What more could a Fed governor want?

Wednesday, April 11, 2012

Probably the most important debate on U.S. monetary policy is whether there really is an aggregate demand shortfall and, as a result, a negative output gap. If the answer is yes, then the Fed should be doing more. If no, then monetary policy should show restraint. Some Fed officials like St. Louis Fed President James Bullard and Minneapolis Fed President Narayana Kocherlakota believe there is no significant aggregate demand or domestic output gap problem and thus want to tighten monetary policy soon. Fed chairman Ben Bernanke, on the other hand, believes there is still ample slack in resource markets and is open to further monetary stimulus. And then there are the MarketMonetarists and other like-minded commentators in the blogosphere who think there is a significant aggregate demand problems since the Fed has been effectively tight since mid-2008. Who is right?

The answer has always been clear to me. But for those still unsure let me direct you to some evidence that makes a very convincing case that there has been and continues to be an serious aggregate demand shortfall. The evidence comes from the NFIB's survey of Small Business Economic Trends. This survey, among other things, provides a question to the small firms of this nation that is relevant to this debate: "What is the single most important problem facing your firm?" There are nine answers firms can choose, but below I focus on just four of them and their recent trends:

The first thing to note from this figure is that concerns about sales or demand became the most important problem. It alone explodes in 2008. Regulation, taxes, and labor quality (sorry
Kocherlakota , no labor market mismatch problems here) did not sharply intensify. Labor quality concerns actually fall and though regulation eventually starts to gradually rise, concerns about demand were and continue to be the foremost among small firms.

There is more to the poor sales data. It closely tracks the unemployment rate and the output gap as seen below. These findings undermine Kocherlakota and Bullard's claims that the CBO's output gap is overstated. For if the output gap were truly smaller and there were no serious aggregate demand shortfall, then one would not expect to see the relationships below.

Sunday, April 1, 2012

John Taylor has a new post praising Robert Hetzel's new book, "The Great Recession, Market Failure of Policy Failure?". As you may recall, Market Monetarists (MM) claim Robert Hetzel as one of their own since he has been making the argument since early 2009 that tight Fed policy ultimately caused the Great Recession. What is remarkable about Hetzel making this standard MM argument is that he did so as a Fed insider. Now it seems John Taylor is becoming sympathetic to the idea (my bold):

So with this interpretation, there is a clear connection between the too easy period and the too tight period, much like the connection between the “go” and the “stop” in “go-stop” monetary policy, which those who warn about too much discretion are concerned with. I have emphasized the “too low for too long” period in my writing because of its “enormous implications” (to use Hetzel’s description) for the crisis and the recession which followed. Now this does not mean that people are incorrect to say that the Fed should have cut interest rates sooner in 2008. It simply says that the Fed’s actions in 2003-2005 should be considered as a possible part of the problem along with the failure to move more quickly in 2008.

John Taylor appears to be really close to my view of monetary policy over the past decade: it was too loose in the early-to-mid 2000s and was too tight beginning in 2008. And like all Market Monetarists, he believes a big reason for these failures is that the Fed did not follow a systematic, rules-based approach to monetary policy. We agree and would like it to be a nominal GDP level rule. If Taylor can buy Evan P. Koenig's argument that the Taylor Rule is just a special case of a nominal GDP level target then he is even closer to Market Monetarism than he realizes.